China or Bust: Recognizing the True Costs of Outsourcing

All that glitters may not be gold when it comes to outsourcing manufacturing productions to China. First, weigh the costs and learn the facts with this helpful guide.

Are you behind the curve to source your products from China? What's taken you so long to make the move? After all, everyone is doing it. And it can save your company some serious money...right?

Well, the answer is yes and no.

There is money to be saved and quality products to be had in China. You can save up to 40 percent of your manufacturing costs, but only if you can avoid the potential margin-eating pitfalls. The caveat being that the management time and learning curve dollars are a burden that few companies want to absorb. Unless you work through experienced domestic suppliers to manage the risks for you, be ready for late nights, early mornings, frustrating phone calls, confusing e-mails, and some long and grueling trips to a part of the world that leaves you longing for a rainy weekend back in Newark.

With offshore manufacturing experience dating back to China before it was fashionable, then to Mexico with NAFTA and now back to China, I can tell you that the game is played the same, but the rules are different everywhere you go. China is a very challenging place from a logistics perspective, and its culture is very different from ours.

This article will cover:

The cost savings of sourcing and/or manufacturing in China

What manufacturing transfers cost effectively to China

The potential offsets to savings

What Cost Savings Can I Realize in Sourcing and/or Manufacturing in China?

Whether you partner with a domestic supplier with Chinese manufacturing experience or take the do-it-yourself approach to outsourcing, the obvious cost savings from manufacturing in China will occur in your direct labor line. An hour of fully loaded labor cost will run about $.50 an hour in China. Living and eating in dormitories on your manufacturing site, employees work 12 hours a day, six days a week. What this immediately suggests is that if you have labor-intensive manufacturing processes, outsourcing them to China may be a good option.

A less obvious saving will come in the cost of materials, such as aluminum and steel, which the Chinese government may subsidize. Moreover, common practice relationships with suppliers may allow you to avoid paying your subcontracted supplier for tooling costs on a new product/component that you may require.

Chinese manufacturing plant overhead is much lower across the board, too. The management team, quality staff, accounting department and engineers will cost a fraction of what they would cost in the United States. And electricity bills, insurance, waste disposal and real estate costs will all be much lower. Totaled, this can add up to as much as saving 70 percent of what you would pay for comparable plant overhead in the United States.

Does All Manufacturing Transfer Cost-effectively?

With all of the companies now based in China you'd think that products and parts would transfer easily to Chinese-based manufacturers. However, this is just not the case. If you choose to outsource, you will need an up-to-the-minute understanding of available manufacturing capacities. And the size, shape, complexity, interdependencies and raw materials required by your production schedule will all need to be factored into your decision to transfer the work.

Realize, too, that Chinese manufacturing is moving away from its heavy reliance on Taiwan-based companies. Many of the complex manufacturing processes that were either dealt with in Taiwan or were invented in Taiwan and transferred to China are increasingly being developed in China. This requires that you understand where the manufacturing expertise resides and make sure that it is solid.

In general, manufacturing in China is not a good fit if your products frequently change. Stable products are a much better fit due to language barriers and the fact that rapid change is still somewhat counter-cultural in China. In addition, the distances between China and other ports of call require that your parts be in-transit for four to eight weeks, which also makes product changes extremely expensive, as products may become obsolete while in-transit. All of the dynamic factors listed above should be taken into consideration when you weight transferring your product's manufacturing processes to China.

Don't Spend Your Savings Yet

Even when your products fit well with the Chinese manufacturing model, when you work directly with Chinese manufacturing operations you may face some serious offsets to your cost savings. Working with an experienced manufacturing partner is one way to protect your company from these costs. Otherwise, you will need prepare for them up front and build them into your business plan.

Training costs for skilled labor and management are often a hidden cost. Your turnover rate could be as high as 30 percent or more, which results in obvious costs such as training and less obvious costs like reduced efficiency and quality. Your biggest turnover will occur just after Chinese New Year in February, as many employees will travel home for the holidays and never return, giving no notice.

You will also feel the effect of fewer skilled laborers and experienced managers, as your plant's internal controls will not be to what you are accustomed. You will write off inventory more often than in the United States, and you will experience higher fall out, scrap and re-work costs as well. Your day sales outstanding (DSO) will run 90+ days.

What Is the Price Placed On Getting Parts to Customers On Time?

Expect to incur very expensive airfreight costs if an order scheduled to ship via ocean is late. All it takes is a couple of airfreight shipments because your plant is running behind to wipe out your cost savings or your profit margin, especially when airfreight is 25 times more expensive than ocean freight (approximately $1.51 vs. $.06 per pound for airfreight and ocean freight, respectively). This is less of an issue if you partner, rather than outsource directly, but can still come into play if your forecasts are wrong.

In any case, to protect your supply chain and/or your customer's supply chain, you may need to keep inventory in the United States and Europe (either in your own warehouses or in one kept by a third-party logistics provider). Remember that boats take a long time to get to the United States, especially to the East Coast, and you can expect a minimum of four weeks transit time, which could be up to eight weeks during the busy seasons. What would happen if you miss a due date to a critical customer, or shut down your line when a boat is stuck off the coast of Los Angeles for two weeks, waiting to offload? To offset this situation, plan to increase inventory levels by four to eight weeks and/or incur hub inventory storage fees to preserve the integrity of your supply chain.

Travel Costs

If you choose to outsource your manufacturing, travel, entertainment and communication costs will be five- to ten-fold what they would be in the United States.

People will need to be sent to China once a month and perhaps even more often on bigger projects. Business class travel is the most practical when you're traveling over 20 hours to Hong Kong, but costs can be prohibitive. Even so, if you want to keep your people you'll need to send them business class the regular trips are grueling and they will be missing home the second day they arrive in China.

Don't underestimate the impact of travel and the time differences between U.S. operations and those in China. Your team will need to work late hours and weekends to keep up with the team in China. Additionally, to keep programs in sync, invest in an affordable conference calling service in order to hold conference calls on a daily basis to keep up with current events.

How Well Do You Communicate?

How well do you communicate as a company and as a management team? If you take on the challenge of managing outsourced Chinese manufacturing operations, you may need to completely change your communication processes. The most important lesson for manufacturing in China is that you cannot over communicate.

The Chinese are a proud and hard working people. They believe that saying we can't do it would be admitting failure, and that is not an option for them. Instead, you will hear we'll try, which really means they aren't quite sure they can do what you asked. Always drill deeper to find out what is causing them to be uncomfortable or where the miscommunication might lay.

Another example is the difference in the terms like samples prototypes and FAI parts that may or may not be understood. These are very important distinctions. Also, drawings don't always translate easily, so be clear and explicit in every detail. And don't assume that because you haven't received a question on what you've sent over that all is well. You'll need to ask for on a daily basis confirmation of details, regular status updates and feedback on what you've sent.

Final Cost Saving Thoughts

Bottom line: Find someone who's done it before. Pick a partner or vendor to work with that has already successfully tackled manufacturing in China. The cost savings are there, but this is no time to let your ego drive, or you may never see the payback from your time investment.

There are many successful U.S.-owned businesses operating in China with global reach in all types of commodities and custom manufactured parts. These companies are already battle tested and will help you keep your focus on your key customers and markets undistracted by mastering the intricacies of international logistics. All you have to do is ask around to find the market leaders in your industry/product space it's a small world after all.

Sidebar: A Real-world Cost Savings Example

Let's work out the savings on a Chinese manufactured part, assuming the same $12 part would have cost you $17 in the United States.

The paper savings at the start are $5 a part, or 400 percent. If you buy $240,000 worth of these parts annually (20,000 parts), you can save $96,000 at a gross level on the parts if all goes according to plan. For the $12 part, the total incremental transportation cost is $1.10 on the ocean, or about $22,000 depending on the final destination (not including premium shipping). If you have to ship the production quantity order on an airplane, all bets are off. The annual net savings in this case would be $74,000.

You'll surely get a pat on the back from your boss for improving your margins, but what about the four to eight weeks of inventory now in your pipeline and the carrying cost related to it? With $20,000 to $40,000 in extra inventory on the books to protect your company's supply chain, you'll pay on average $100 to $125 an order (in, out and storage fees). Assuming you keep four weeks on hand and pay to hub the inventory, your additional logistics costs will be about $7,000. Now your net savings would be $67,000 or 28 percent. This is still a very nice contribution to the bottom line, but it's clear how important it will be to make sure all of the product ships via the ocean the forecasting and hub inventory management will need to be 100 percent accurate to ensure the savings.

About the Author:George Dannecker is CEO and president at Vette Corp. www.vettecorp.com.